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Fixed-Income Insights

Discouraged by low or negative rates on many investments? There are still attractive income alternatives in select asset classes.

 

In Brief

  • Income investors have struggled with a lack of acceptable income vehicles over the past few years, and they face a challenging environment in 2016.
  • Key headwinds include negative yields in many global fixed-income sectors and concerns about the growth prospects for major global economies.
  • But a survey of various investment categories indicates potential income opportunities in, for example:

               –U.S. short duration investment grade debt;
               –U.S. high-yield securities;
               –U.S. high-dividend stocks; and
               –Select non-U.S. investments

  • The key takeaway—Despite a growing universe of bonds with negative or low yields, investors still have opportunities to construct an income-producing portfolio.

 

Investors have struggled with a lack of acceptable income vehicles over the past few years. The environment in 2016 seems even more challenging. Yields on most U.S. government securities are now lower than before the U.S. Federal Reserve (Fed) raised rates in December 2015. The supply of attractively priced sovereign debt outside the United States has been reduced by the negative interest-rate policy (NIRP) and aggressive debt purchases of central banks in the eurozone and Japan. And investors who ventured into riskier investments, such as master limited partnerships, to capture high income have experienced unwelcome volatility.

But there are, we believe, income opportunities to be had in 2016. In some instances, they even may be better than comparable investments in 2015. However, whether or not they are appropriate for investors depends on considerations such as the potential spread, and investment impact of, negative interest rates; the volatility of major currencies; the potential effect of China’s economic slowdown on global economies; and the expected pace of growth in the United States.

Here, we survey some major investment categories to assess their potential appeal—or lack of same—to income-oriented investors.  

Non-U.S. High-Quality Debt
Aggressive monetary policy in the eurozone—including a dramatic stimulus package announced by ECB president Mario Draghi, on March 10—and Japan has pushed many government yields into negative territory and pulled the positive yield on other high-quality corporate debt in those countries closer to zero. Investment opportunities in non-U.S. high-quality debt appear bleak. At the end of February, for example, JP Morgan reported that $6.4 trillion, or more than 27%, of its global government bond index was trading at negative yields. While the negative yields on these securities affect investors around the globe, the situation is especially unappealing for those in the United States. Why? Because central bank policy actions are designed to devalue the underlying currency, whether euro or yen, the offerings are even less attractive to U.S. investors. With negative or low yields and risk of currency losses, non-U.S. high-quality debt does nothing for U.S. investors seeking income.

U.S. High-Quality Debt
Low or negative yields in the eurozone and Japan also have dampened yields on U.S. debt. Investors faced with negative yields in the eurozone and Japan find better offerings in the United States, as well as the potential for U.S. dollar appreciation. In this environment, then, it is not surprising to find U.S. government yields lower than they were before the Fed raised rates in December 2015.

The Fed’s monetary policy remains an important consideration for U.S. investors. Yields on U.S. Treasuries, already made artificially low by sizable foreign purchases, remain susceptible to the Fed’s commitment to gradually raise U.S. rates to “normal.” While the Fed seems unlikely to raise short-term rates the four times, or 1.00%, it projected in December, even two rate hikes could create return problems for longer-term, high-quality U.S. debt. According to Bloomberg, an increase of only 25 basis points (bps) in the yield of 10-year U.S. Treasury notes (based on a 10-year subset of the Bloomberg U.S. Treasury Bond Index), from 1.90% to 2.15%, over the next 12 months would translate into a negative total return on such an investment. Short-term Treasuries offer less volatility, but the price reduction associated with a 50 basis-point move for a two-year subset of the Bloomberg U.S. Treasury Bond Index—about 0.97%—will still be greater that the contribution of income, about 0.89%. Again, investors would see a negative return over 12 months.

One potential investment solution would be to find securities with less volatility but greater income. A portfolio of one- to three-year U.S. corporate bonds might be a step in the right direction. For example, the representative BofA Merrill Lynch 1-3 Year U.S. Corporate Index features volatility similar to that of the two-year U.S. Treasury index. But its higher yield of 2.15% (as of March 4) would be sufficient to offset the price adjustment associated with a 50 basis-point rate hike. Based on the index’s yield, and its effective duration of 1.88 (as of March 4), the total return to an investor, if interest rates rise 50 bps over a 12-month period, would be about 1.2%, which is much better than the slightly negative return on the two-year U.S. Treasury index.

What could be even more appealing to income-seeking investors who want to avoid interest-rate risk would be to include securities in the lower tiers of investment grade, some exposure to high yield, and the use of commercial mortgage-backed securities (without extending maturity). Such a strategy would also allow a review of new opportunities should interest rates adjust higher one year hence.

U.S. High-Yield Securities
If the income of short-term corporate debt can overcome the price adjustment resulting from gradual rate hikes, extending the theme to high-yield securities may offer another compelling income solution. This strategy may benefit from 2016 yield spreads (750–800 bps relative to U.S. Treasuries of comparable maturity, based on the J.P. Morgan Domestic High Yield Index) that are much higher than historical averages (500–550 bps). In addition, in past rate-hike cycles, high-yield securities generally have performed better than a high-quality alternative, such as the Barclays U.S. Aggregate Bond Index, based on our research of the Fed’s five rate-hike cycles over the past 30 years.

Continuing our example of two, 25 basis-point Fed rate hikes in the next 12 months, the BofA Merrill Lynch High Yield Constrained Index, with duration of 4.26 and a yield to worst of 8.59%, would offer total returns of 7.52% and 6.46%, respectively, if the index yield moved higher by 25 bps or 50 bps. If we allow for defaults to increase, to 4.0% (from an average of 1.4% for the past three years, according to JP Morgan), and recovery rates of 40%, the 12-month returns adjust to 5.12% and 4.06%, respectively, for 25 basis-point and 50 basis-point rate increases. For investors who are comfortable with the credit risk of high-yield securities, such a strategy could play an important role in an income portfolio.

Similarly, bank loans, which populate many floating-rate funds, offer even less interest rate risk than traditional high-yield debt, yet provide relatively attractive income. And the universe of bank loans contains less exposure to the energy sector than traditional high yield.

U.S. High-Dividend Stocks
For investors comfortable with equity volatility, high-dividend stocks may also be considered as part of an income strategy. As of March 1, 2016, Wolf Research noted that 49% of large-cap U.S. stocks had a dividend greater than the yield on the 10-year U.S. Treasury. In addition, 49 companies had dividend yields in excess of the yield on their own 10-year debt. Persistent U.S. growth, driven by additional jobs, higher wages, continued improvement in housing, and an increase in government spending, could provide investors additional comfort in using equities as part of an income strategy. For those concerned about performance amid the Fed’s planned policy normalization, it may be comforting to know that over the last 30 years, the S&P 500® Index provided positive returns in each of the five rate-hike cycles that the Fed pursued.

Non-U.S. Investments
Investments outside the United States could also be part of an income strategy, but demand separate treatment due to other risk considerations, including currency risk. Of particular interest may be high-dividend stocks, which tend to be more plentiful outside the United States and can offer higher dividends than their U.S. counterparts as well as important portfolio diversification. Emerging market debt also is a worthy consideration. Yields are consistently higher than comparable credits and maturities in the United States. Opportunities exist in both sovereign and corporate emerging market debt, but the asset class demands selectivity and active management. Why? Active managers may be best positioned to guide these portfolios as a slowdown in China increases the urgency to avoid countries and companies that are poorly diversified and, unfortunately, focused on commodity exports that are under price pressure from abundant supply and reduced demand. At the same time, professional managers may be able to capitalize on countries and companies with more favorable trade profiles and improving political risk.

Summing Up
Despite a growing universe of bonds with negative or low yields, investors still have opportunities to construct an income-producing portfolio. Unfortunately, U.S. and global debt issues of the highest quality are among those securities that offer relatively unattractive yields. In addition, the currency risk of many non-U.S. high-quality securities may further compromise returns. Meanwhile, even modest Fed rate hikes could turn low U.S. Treasury yields into negative returns over the next year or so.

What might be a good course for investors to take? Strategies that include short-duration investment-grade debt, high-yield securities, high-dividend stocks, and select non-U.S. equity and fixed-income vehicles can be assembled to provide an income solution for many investors. Recent price declines in the high-yield and equity markets, both domestic and global, may present better opportunities to build an income-producing portfolio than could have been assembled even a few months ago. And the historical performance of U.S. equities and high yield relative to high-quality debt during past Fed rate-hike cycles may provide added comfort for investors fearful of a Fed determined to normalize rates over the next several years. 

 

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